Thursday, September 26, 2013

On this website, special care is
made to highlight the risks inherent in the various investment themes and
economic developments covered. Put another way, an attempt is made to shine light
on potential outcomes that may proverbially blow one’s fingers off. Despite
receiving top billing in the bedrock investor paradigm of risk/reward, the concept is risk is often overlooked by many
casual, and sometimes professional, market participants. The emphasis on
seemingly sure-thing rewards is only aided by the torrent of rosy forecasts by
policy makers and brokerage firms, not to mention ubiquitous television
commercials where one is led to believe that every investor is an uber-fit,
50-something male, successfully trading from his veranda overlooking the
Pacific coastline.

Yet recent history is filled with
examples of the carnage that ensues when investors either misprice risk or
patently ignore it altogether. We had the exuberance
of the dot.com bubble, the cleverly dises
of the carnage that ensues when investors either misprice risk or abjectly
overlook i-engineered mortgage backed securities meant to diffuse risk,
which in the end turned out to be not-so cleverly engineered, and presently
U.S. equities are hitting record highs, despite dubious fundamentals and weak
economic growth. In this most recent iteration, one cannot entirely blame
investors for grossly deviating from what sound math might otherwise lead them
to believe the intrinsic value of securities to be; instead they have been pushed
into asset classes further out along the risk spectrum as the Federal Reserve
crowds out safer investments, which would otherwise be more appropriate for portfolios
during a period of uncertainty and tepid growth. This distortion of demand for
riskier assets has been a pivotal factor in allocation decisions for the past
three years. Not good. Think of startled lemmings and their fate just beyond the
cliff.

Peeling Back the Risk Onion

Any economic endeavor entails
risks. Start a business and you are putting your capital on the line. Buy a
house and the market may tank or obnoxiously loud Broncos fans may move in next
door. Risk is inherent in financial markets. Yet not investing invites risks of
its own, especially when factoring in longer life expectancy (a good thing), a
lack of savings my most Americans (a bad thing) and the house-of-cards financing
of the social security system (something abhorrent). Once in the market, the
calculus becomes only more complicated. As a result of the Fed’s Treasury purchases
enabling bloated deficits, everyone is exposed to the risk of a declining
dollar….. that is monetizing the debt, making it vanish through inflation. This
generational theft punishes savers
the hardest, especially those whose portfolios are geared towards the cash-producing
fixed-income instruments most sensitive to inflation.

But these hurdles exist too far out
into the future to rattle the average short-sighted American (and especially his/her
elected leaders). There are, however, plenty of immediate economic and
investment risks to keep us awake at night. Thanks to the massive shadow of the
Fed’s accommodative policies, many of these are either directly or indirectly
tied to the central bank’s future moves. These risks are manifested in different ways
across asset classes. Additionally, specific forms of investments have acute risks
based on their inherent characteristics. The textbooks call this diversifiable
risk, but as 2008 brutally illustrated, that term proved a bit elusive.

The Fed’s Long Shadow

Much of the conversation
surrounding the Fed’s quantitative easing has been on its demand for
Treasuries. Lost in this is the torrent of supply emanating from the federal
government. While down from its crisis peak of 13% of GDP, the government
deficit remains elevated. Given weak growth, revenues from taxation on a
(welcome) increase in economic activity remains a pipe dream. Furthermore,
gross government debt has crested 100% of GDP and is expected to remain there
for the foreseeable future. Most troubling is the deficit is effectively being
subsidized by the rock-bottom interest rate regime in place since the advent of
QE. Should rates begin to creep up…as had begun to occur beginning in May,
before Chairman Bernanke quashed tapering talk…..the interest rate component of
the deficit will rise, shooting the debt into even more stratospheric
territory. Throughout the 1980s and 1990s, federal government interest payments
averaged 2.8% of GDP. During the great
moderation of interest rates during the early 2000s and into the
post-crisis QE era, the average has fallen to 1.6%. Should rates normalize,
interest payments on government debt will make solving chronic deficits all the
more arduous. We call that a death spiral.

Given the status of U.S. Treasuries
as the…..ahem….risk free benchmark
for much of the investment universe, the deficit/debt conundrum will have repercussions
far beyond the market for U.S. government paper. One potential flashpoint will
be the dollar. The risk….well temptation….to vaporize the debt via the
continual torrent of fiat dollars could catalyze persistent inflation, which
when unleashed, would prove difficult to reign in. These debt levels, along with a weaker dollar,
could finally cause major investors, namely foreign central banks, to dial back
their exposure to U.S. government securities. The ensuing drop in demand and
consequential rise in interest rates would serve has yet another drag on
business expansion and consumption. Not what the economy needs.

Bonds: Not the Safe Haven of Yesteryear

The worst kept secret in financial
markets today is the risk facing fixed-income instruments once the Fed pulls
back its support for bond market. At a yield of 0.34% on the 2-Year and 2.6% on
the 10-Year, it does not take much of a drop in principle to wipe out any
coupon payments attached to these securities.

The first destination along the
risk spectrum for investors seeking to meet their investment obligations is the
corporate bond market. As seen below, yields
on investment grade corporate debt reached record lows during 2012, following
the trajectory of the 10-Year benchmark, and have only slightly risen since
then. The spread on BAA bonds over benchmark is only 268 basis points, compared
to a post-crisis average of 319 bps. In the absence of interest rate support
from Fed purchases in addition to spreads rising once investor demand cools,
prices across the fixed income universe likely have only one direction to go:
south.

Stock Market Optimism….Or Complacency

When viewing the path of the
S&P 500 over the past two years, one could deduce that there is not a care
in the world. This is compounded when noticing that the VIX Index, the market’s
fear gauge and thus a measurement of
risk aversion, is 40% below its long-term average.

Fed policies have certainly pushed
yield-starved investors into equities over this period, raising prices along
the way. Corporate income statements have also benefited from the low interest
rate environment by locking in long-term financing at a bargain. Even if rates
start to climb, stocks could see a benefit if a) it was a consequence of the
sustained economic growth needed to fuel top lines, and b) it loosened up the
purse strings of banks to make more loans at a respectable profit. The flip
side is that loans that have already been made….and there has indeed been
progress on this front…could see their rates reset at a higher level. This is
especially the case for firms with more questionable credit quality.

The other main risk to equities is
that investors may finally wake up. One major driver of stocks (GDP growth) has
been a dud and another (productivity gains) have been squeezed dry. According
to S&P data, EPS growth has slowed to a snail’s pace. Despite this, the
forward P/E ratio of the index presently sits at 14.7, still marginally
attractive. Investors have continued to focus on the fact that in relative
terms equities remain cheap, but that does not factor in the suspect landscape.
Should a rerating occur, say down to a more plausible P/E ratio of 13, the
S&P 500 could lose 12%. And that is keeping forward earnings estimates
constant, ignoring the recent history of expectations being repeatedly pared.
Should that plausible scenario occur, a sell-off could potentially reach bear
market territory.

Next Stop Along the Risk Spectrum: Emerging Markets

Emerging market investors (and
policy makers) were the first to experience the volatility caused by Fed
intervention into financial markets. As seen below, once the FOMC opened the
door to the possibility of tapering bond purchases in May, the MSCI Emerging
Markets Index lost 17% in short order. While much of that has been recovered,
the fall shows how sensitive these markets have become…rightly or wrongly…to
the perceived support of risky assets by Fed policy. The remainder of the chart
illustrates the volatility inherent in emerging markets as hot money investment flows often overshadow country specific
fundamentals. Maybe it’s not fair, but that’s how the game is played these
days.

With regard to country-specific
risks, the laundry list of potential red flags in emerging market investing is
well-known: opacity, illiquidity, lousy shareholder rights, corruption,
populist protectionism (which could apply to certain unnamed advanced economies
as well), and a weak track-record of fighting inflation and currency instability.
It is with irony that many emerging market policy makers complained first about
hot money inflows on the back of QE only to gripe even more when flows
reversed, weakening their home currency and igniting fears of imported
inflation. Yet distorted demand for emerging market assets is also providing a
window of opportunity for countries to reform their economies and institute
sound fiscal and monetary policy. Once QE ends….as all good things must….investors will seek out destinations which made
strides in positioning their economic systems for the next iteration of growth.
Others could follow the path of Argentina.

Commodities: Can Fundamentals Rule the Day?

If we had had a conversation about
the relationship between Fed policy and commodities three years ago, the tenor
would have been entirely different. From the onset of the financial crisis to
the announcement of QE2 in August 2010, the SPGSCI Commodities Total Return
index bumped along the bottom. After Chairman Bernanke’s Jackson Hole speech that
month, the index shot up 42%. This led to cries of commodities bubbles fueled
by loose monetary policy. While there still may be something to that argument
(we’ll save it for another day), fundamentals have for the most part retaken
their position as the main driver in commodities pricing.

Being the role commodities play as
key inputs in industrial applications….and in our mouths and gas tanks….
fundamentals are largely determined by economic growth. And therein lies the rub. Growth…even in
emerging markets…has yet to return to pre-financial crisis levels. The
consequent lack of demand has kept a lid on many industrial inputs. What’s
more, the buy-in of the commodities supercycle concept was so strong that
buckets of capital investment and technological innovation were deployed to
meet rosy future demand projections. This new pipeline of supply, when accompanied
by soft-demand, presents downside risks to the prices of securities associated with
the commodities space. North American shale oil and natural gas are prime
examples of the shift from strong demand factors to abundant supply steering
the market. At least with commodities, the cost of production sets a floor to
prices, as producers will idle capacity once prices dip below that level.

Headline Risk

Can we discuss risks to financial
markets without mentioning contemporary headline-grabbing developments such as
the misfiring Arab Spring and the carnage in Syria? While these events may
cause ephemeral spikes in oil prices, one must remember that neither Syria nor
Egypt have significant crude reserves. Yet there is real political risk to
developments in the Middle East, not only due to the fact OPEC continues to
account for roughly 40% of global oil capacity, and the shipping lanes of
Hormuz and Suez could easily be compromised, but also because of the simmering
Shia/Sunni sectarian violence that is manifesting itself across the region.
There is a lot of oil within close proximity of that fault line.

The latest round of Washington’s
budget and debt ceiling battle also provides fodder for the financial press. While any impact on markets may be
short-lived, some good may be served by shining a light on the government’s
aforementioned debt/deficit problems. Or the can once again gets kicked down
the road, which will only magnify market…and real economy…risk once the day of
reckoning arrives.

With the launch of major parts of
Obamacare only months away, opinions abound as to whether there will be aggregate
cost savings or greater outlays required of business and consumers. Time will
tell, but as a rule, greater regulation, either in healthcare, energy or
financial services, often leads to great ossification of the economy. Just ask
France. This is not what timid corporate managers or chronically underemployed
consumers want to experience if either group is expected to contribute to the
economy ever reaching escape velocity
from this drab new normal.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.